The New Normal

In March 2014, I wrote the following for DailyFunder.com: I think we are either currently in, or are fast approaching a “market bubble” in MCA. Bubbles never end well…When I see some of the business practices, offers, terms and other aspects of our business today, I am worried…assets are being overpaid for through higher than economically justified commissions …and [funders are] stretch[ing] the repayment term of the MCA or loan even further. I went on to say that this felt to me an awful lot like the subprime mortgage meltdown of 2008.

Like all good bear market prognosticators, I was a touch early in my forecast. 2014 and 2015 were continued boom years for small business alternative lenders (or “small business Alt Lender.” I don’t agree with applying the moniker “online lender” for our industry. It might be sexy, but it’s not accurate.) Loan and MCA terms got longer, loan pricing to the client dropped further, companies grew 100% year over year. And then 2016 happened.

The most shocking event for me in 2016 was the disruption at CAN Capital. They had the most data, the most experience, market dominance, and the most in-depth institutional knowledge. The granddaddy of all of us. Not far behind is the fiasco that is On Deck, the only publicly traded small business Alt Lender. In the past 12 months alone, the stock price has declined by over 40%. And that is after a roughly 50% drop in stock price in 2015. The first 9 months of 2016, driven in part because of market required changes to their business model when they could no longer profitably sell a sufficient volume of loan originations, they have a GAAP net loss of almost $50 million. There have also been a number of other lesser but still high profile failures, shutdowns, and exits from the industry in the past several months alone.

So what is driving this abnormally high rate of failure in the Alt Lending industry? Is it the “New Normal?” And what do I think lies ahead in 2017 and beyond? Before revealing my personal crystal ball again, I will share an anecdote from earlier in my business career.

I was the CFO (and eventually CEO) of a profitable, long-tenured family owned construction company. We had a working capital credit line from a major bank secured by a first position lien on our accounts receivable. The credit line was also personally guaranteed. We borrowed from the credit line for three reasons. For cash flow, when our receivables paid more slowly than expected; we had tax payments due; or we purchased a large piece of equipment. We always paid back the draw on the credit line as quickly as we could, to keep interests costs low, to impose cash management discipline, and to create future availability on the line once repaid.

The credit line was for one year. It was always renewed. But I was frustrated to have to go through an annual underwrite process with our bank, despite the personal guarantee, consistent profitability, and that we always paid back our draw on the credit line. Our banker (patiently) explained to me that economic cycles changed, and medium sized businesses – we had about 200 employees – suffered ups and downs and sometimes became financially distressed and even went out of business. The bank wanted to protect their position and not overextend the term of the credit line.

When I started RapidAdvance in 2005, I drew on my personal knowledge and previous experience as a borrower. The products we offered made sense based on our customer profile which was main street small business. We needed to protect against economic cycles and the high rate of small business failure. The maximum term offered by any company in 2005 was 8 months, at that time only for an advance product (future purchase and sale of credit card receivables), not a loan. Payment was received daily through a credit card split, thus allowing for a future capital advance (renewal) within about five or six months as the open advance was paid down. Cash advances could be used for taxes, equipment purchases, or business expansion. The price of the product reflected the risk of the credit offered.

What many in the small business Alt Lending industry seem to have forgotten, or never learned, is that our business is fundamentally a subprime credit industry. We are either lending to subprime borrowers, because of either the personal credit of the owner or the balance sheet of the borrower, or if the credit is strong and the business is more substantial, the loan itself is a subprime risk because we are at the bottom of the capital stack – behind the bank loan, the business property mortgage loan, the other personal guarantees of the owner, the factoring company, etc. We are taking the most risk. To offer two and three year terms and to try to pretend to get to “bank like” rates is, in my opinion, committing lending suicide.

At Rapid, we were dragged kicking and screaming into slightly longer term and lower cost products in order to stay competitive with certain customers. But we have kept that pool of customers as a very small percentage of our overall receivables.

Going into 2017 and beyond, I see five major trends. First, terms will get shorter, prices will increase, and offers will become more rational. That is already happening. Second, capital to this industry will become less available. The best companies with proven data driven models, consistent underwriting, a strong balance sheet and predictable loss rates will get financed. The days of easy money chasing this space are over. Equity will be particularly hard to come by.

Third, there will be continued disruption of funding companies. Companies will consolidate and some will disappear. On Deck may be in for a big challenge. They had a tremendous cash burn converting their business model to more balance sheet financed instead of originating and selling loans. Their market cap today is approximately book value, i.e. if you could buy up all the shares of the company at today’s trading price that would be roughly equal to their cash on the balance sheet and the value of their net receivables. The next two quarters are crucial for them to show the market they have turned the corner to become a self-sustaining lender. I am not optimistic, but I am rooting for them to succeed as it is in the best interests of the industry.

Fourth, stacking will continue to be an issue. I believe that the legal system over the next few years will bring some semblance of order to this industry scourge. At Rapid we have taken an aggressive legal stance against stacking, with some success in the courts. The challenge is that each situation is fact specific, and to prevail in a claim of tortious interference, the first position lender has to prove damages. I think that an unrelated decision at the end of 2016, Merchant Funding Services, LLC vs. Volunteer Pharmacy in New York State, could be a game changer. Because of the form of contract and the business practices in Volunteer, the judge ruled that the transaction constituted criminal usury. Knowing the business practices of the stackers, specifically the practice of writing an agreement that pretends to be a sale and purchase of future receivables but is in fact a loan, which is the basis for the judge’s ruling in Volunteer, I can see lawyers seizing on this precedent to help overstressed small business owners attempt to void their stacked loan agreements. The small business would first block the stacker’s ACH, claim the contract is void because of criminal usury, and then sue the stacking company. There could also be class action lawsuits like we saw a few years ago in California – bundle together a number of these claimants and go after the deep pocketed investors and banks that finance the stacking companies. The State’s Attorney General in New York may take a public policy interest in these types of loans. Once the dominoes start to fall, the costs of stacking – litigation and unpaid loans, in addition to proactive claims for damages – could be enormous for both the stacking companies and their owners and investors.

Lastly, and to my great pleasure, I think we will stop hearing small business Alt Lenders calling themselves “Fintech.” I think we will see the beginning of the demise of fully automated, no manual touch funding. At Rapid we have data and risk and pricing algorithms but we have always had an underwriter at a minimum review every file. At conferences when I have presented or participated in Fintech panels I always referred to Rapid as a technology enabled, non-bank small business lender. Now even On Deck describes themselves in similar terms.

I titled this post “The New Normal.” In the classic Mel Brooks movie Young Frankenstein, Dr. Frankenstein sends his assistant Igor to steal a brain from a cadaver to implant into his monster. But Igor accidentally drops the genius brain he was supposed to steal, and brings the doctor a different brain without telling him. When the monster awakes and has the personality of a psychotic five year old, Igor tells him he brought him a brain that was labeled “normal” instead of the one he was supposed to steal. It was, as Igor read it, “Abby Normal.” Abnormal, I believe, is the “New Normal” we will be dealing with in 2017.